Years ago when I was thinking about switching careers to become a financial advisor, I was sure the secret to financial success was investing. I had read a number of the classics on investing – Peter Lynch, Benjamin Graham, Phillip Fisher – and I thought it was all about stock picking. I was wrong.
I was wrong because stock picking is hard, and most investors don’t succeed – or at least they don’t beat the markets. But I was also wrong because there are several keys to financial success that are far more dependable than trying to pick stocks. Those include our biases in how we think, trying to improve our decision making and building good financial habits. I have read a good bit on all three subjects, and there are several books I would recommend.
Behavioral finance looks at how we think about financial matters, and its study has blossomed over the last few decades. Contra traditional economics, behavioral finance starts with the assumption that we are not purely rational when we make our decisions. We have a number of flaws in how we approach certain issues (I cover a few of them here, here and here) that keep us from making logical, optimal decisions.
Many of these flaws are the result of how our brains evolved, and as a product of this evolution, we have a two-tiered approach to thinking. One of the seminal books in explaining this cognitive framework is Thinking Fast and Thinking Slow by Nobel prize-winner Daniel Kahnemann. I first covered the book here, and the crux of it is that we have an “automatic” system in which we react without thinking, and a more logical – but a much slower system and energy-intensive system – in which we deliberate rationally before acting.
Using the “fast” system can lead us to make decisions that aren’t in our best interest financially, and that in some cases are actively harmful. Dan Ariely explores some of this sub-optimal decision making in his book Predictably Irrational. He focuses on financial decisions more generally as opposed to just investing, and his analyses of how we can be manipulated in purchasing decisions and how we value (or misvalue) things is insightful. If your goal is to understand how you can maximize the value you get from the money you spend, reading Predictably Irrational is an excellent place to start.
Once you learn to recognize flaws in your thinking, you can come up with a clearly defined process for decision making. This is particularly key when it comes to investing, so it’s no surprise that Ray Dalio found it to be essential in building Bridgewater Associates, the world’s largest hedge fund. Dalio provides a general outline of his process – along with a great deal of other information – in his book Principles. Dalio focuses on how to value input from others when making decisions as well as how teams can approach decision making. He also spends a bit of time on probabilistic decision making which involves trying to assess the likelihood of various outcomes and making your decision based on those probabilities.
Thinking in Bets is more tightly focused on formulating a process for decision making. Author Annie Duke was a successful professional poker player, and she credits her success on having a clear process for decision making when there are many unknowns and many possible outcomes. We have found this approach to decision making to be very useful in building portfolios. There are numerous possible outcomes of varying probabilities, and the goal is to design a portfolio that achieves a target level of return across a range of outcomes
One final key to financial success is developing good financial habits. Because investment returns compound over time, doing the right things over an extended period is more impactful to your finances than just about any other area of your life. Whether it’s budgeting, savings or some other financial habit you want to acquire, understanding how habits develop makes it more likely you’ll be successful. The Power of Habit (reviewed here) covers this ground ably, and you might find Stick With It helpful, too, although the latter title is a bit repetitive.
You’ll still need to pay close attention to your investments, but understanding your blind spots and improving your decisions making will help you do that. If, in addition to doing those things you focus on developing strong financial habits, you’ll greatly improve your odds of achieving your financial goals.